Friday, 9 December 2016

Market Timing Theory

Origin:

Market
timing theory is one of most important theories evolved for capital structure
of the firm. Firms have two main ways to finance their business either through equity
or debt financing. In 2002, Bakers and Wurgler introduced Market timing theory.
Their study claims that the Market
timing is the primary request determinant of a company's capital structure for
the utilization of equity & debt. Firms are only concerned with those ways
which gives them higher opportunity of profits. Market timing is a dimension of
Behavioral Finance which depicts firm’s tactics towards market fluctuation. This
theory proposes that Managers can help the best for the firm to lower its cost
of capital. Equity issuance at the time of high valuation is very beneficial to
the firm. Baker and Wurgler finds that low influential firms are those that
raised assets when their market valuations were high, as measured by the
market-to-book proportion .On the other hand high influential firms are those
which raised assets when their market valuations were low. This additionally
suggests, for outside financing decisions, firms lean toward outer value when
the cost of equity is low then they favor debt sources. Firm’s techniques
towards market timing ultimately affects capital structure of that particular
company.

Since
1977, timing behavior of firms were indirectly tested. Till 2001, a proper
theory was not introduced. (Hovakimian, Opler, and Titman 2001), (Pagano,
Panetta, and Zingales 1998), (Bayless and Chaplinsky 1996), (Rajan and Zingales
1995), (Choe, Masulis, and Nanda 1993), (Asquith and Mullins 1986), (Jalilvand
and Harris 1984), (Marsh 1982) and (Taggart 1977) indirectly tested the timing
behavior of firms. In these studies Market to book ratios and debt to equity
ratios were also used as variables. Basically these concentrates on some other
different issues of capital structure.

(O’Brien,
Klein, and Hilliard 2007), (Kayhan and Titman 2007), (Hovakimian 2005), (Alti
2006), (Elliott, Koeter-Kant, and Warr 2004b), (Huang and Ritter 2004) and
(Korajczyk and Levy 2003), generally approves (Baker and Wurgler 2002)
findings. But main conflicts are present where this study says that there is a
long term impact of market timing on capital structure while other researches
discovers that with 2 years era effects of timing behavior disappears.

Implications
of Market Timing Theory:

In the efficient market
predicted by Modigliani and Millar (1958) the cost of financing do not differ
of different types of finance (debt/equity) and therefore, choosing among the
two do no hold much difference. However, under the inefficient markets, the
cost of finance holds great importance, as it ultimately effects the
performance and profitability of a firm.

Baker and Wulgler (2002)
investigated that how capital structure is affected by equity market timing.
Using all Compustat firms’ basic regression equations has been used to test how
capital structure is affected.The
results have showed consistency with the hypothesis of the study that capital
structure is largely effected by market timing. Leverage is used as dependent
variable, whereas market timing opportunities measured as market-book ratio
which are perceived by the managers of firm. These are weighted average past
market-book ratios. Results showed that leverage is negatively associated to
past market valuations. The results showed that low leveraged are the firms that
collect funds when the market valuation of firm is high. In contrast, high
leverages are the firms that raise funds during the period of low market
valuations. The results also showed that capital structure is largely effected
by fluctuations of market valuation, that continue for a decade. The results
remained significant whether leverage had been measured with market or book, or
whether other control variables (tangibility, profitability and tangibility had
been included.

As a result, the author
concluded that capital structure is strongly affected by past market values.
For example, capital structure of year 2016 will highly depend upon
fluctuations in market-book ratio values from 2006 or even before. Therefore,
the theory states no optimal structure of capital, rather

Lee and Rahman (1990)
empirically investigated the selectivity performance and market timing using a
sample of mutual funds. Regression technique has been used to separate ability
of stock selection from market timing ability. Using a modified form of
security market line, inputs used are individual return as well as market
portfolio returns.

Later in the study he
argued that good performance on part of manager occurs when he is able to
manage the time (market timing) with his ability of forecasting individual
assets returns (selection ability).

During selection of
selection and timing ability, manager's forecasting ability must be separated
in two components:

Micro forecasting is
called security analysis whereas Macro forecasting is called market timing.
Macro forecasting refers to as forecasting future realizations on part of
market portfolio. Macro forecaster will capitalize in anticipation he may
receive regarding market return behavior in next period. If manager believes
that he can earn better than market returns, portfolio risk will be adjusted in
expectation of positive market movements. On a successful anticipation a
manager could earn much higher return than just average market return. If a
manager correctly perceives that high probability has been seen of having high
market returns in the upcoming period, manager would be able of earning higher
return on portfolio through increasing the risk. On the other hand, he could
reduce losses by reducing risk of portfolio. Therefore the manager will switch
from higher risky to low risky securities by outguessing correct movement of
market.

The results founda significant relationship of forecasting
ability on part of fund manager, stating that funds having no forecasting
ability will be considered a passive management and provide just a source of
diversification service to shareholder . Kon (1983) and Henriksson (1984)
stated negative relationship between market timing and selectivity measures.

Deesomsak, Paudyal and Pescetto (2004) states that
under efficient capital markets predicted by Modigliani and miller (1985), the
value of firm is viewed as independent of the capital structure and therefore ,
debt and equity are considered perfect substitutes over each other,
howeverif the assumption is relaxed
then the choice of determining capital structure becomes an important factor.
The study has investigated capital structure determinants in four Asia pacific
countries with regard to existing empirical and theoretical literature.

One of the explanatory
variable the study has taken is share price performance supported by market
timing theory along with other independent variable like tangibility, firm
size, profitability and liquidity.Its
expected theoretical relationship is negative and is mostly reported as
negative with leverage in the empirical literature.

Literature found to
have impact on capital structure of firm. Due to irregular information between
outside investors and managers, new shares will be issued at discount. If the
equity is issued during the overvaluation of shares, the cost of discount to
present shareholders will be very small or even none. Therefore, the preference
of firms are equity over debt during the high share price of firms' share.
Leverage and share price performance are inversely related, as predicted by
theory of market timing (Baker and Wurgler, 2002).

The
empirical testing showed that share price performance are found to have
significant but negative relationship with leverage in all tested countries.
The study proved the negative relationship between leverage and SPP and stated
that during higher share prices firms prefer equity over debt. The negative
relationship provided support to the existing theories of capital structure.

(Hochberg and Muhlhofer 2011) Basic purpose behind this study
was to check how this market timing works for a manager in a real estate
business. How they make abnormal profit out of the opportunities provided by
the investors.

Two
methods by Daniel , wermers and titman (1997), characteristic selectivity and
timing to check the behavior of private and public sector in a real estate
business andinvestor’s overall
selection and profitability measures. Both, private and public entities data
was collected for the evaluation of investment selection. Private sector was
far behind in making successful and profitable investment decisions compared to
public sector.

One
of the influential aspect was managerial skills, how to tackle the particular
situation in a given period. According to finance literature, manager’s role in
earning abnormal profits and time to market for investment purpose is still a
debatable.

Different
aspect of making investment was observed by the portfolio managers like in real
estate business. Author adopted Daniel et al.1997 way of timing and selectivity
to time the market while investment by both private and public sector
managers’.

Top
portfolio manager in both private and public considered to be as the successful
market timers. Though variation in both portfolio managers been found that who
run it better. Further to analyze this particular aspect in a manager’s ability
to find perfect investment to be invested in, a systematic relationship was the
ultimate solution to figure it out.

The
most significant side of the study was, how the time to market which was a
component can be tackled by the managers in the real estate market. How the
managers are making abnormal earning out of it.

(Nasiri and Serkani 2012) In stock market the most essential
decision to find the perfect method to select either from borrowing or through
offering more shares, in corporate financing. Market time theory was the theory
chosen among different theories in order to examine the issues in the financing
methods. To check the effect to MTT, regression analysis was done for the
selected companies of TSE (Tehran stock exchange).

In
this part of survey, we measure the effect of the ratio of market value to book
value on the sources of financing firms though increase in equities. Before
going further research on the theory, past results by using M/Bs was found as
well. Which says firms use the equity more to increase shares. The above
opposed to hypothesis from which one of it is confirmed other is still in
discussion that is ratio of market to leverage relationship.

Two
prospects which the authors did not examined to test the theory was Elliott et
al.’s (2007) financing deficit and earning based techniques. Reason behind the
rejection of these two points, they were misinterpreting the use of equity
valuation. A year later, in 2008 the author examined the MTT refer to capital
structure with separate evaluation for both the equity and finance deficit.
Which in result helped in preventing the explanation given by M/B ratio
analysis. In the same year Mahajan and Tartaroglu studied the major chunk of
industrial sector and came up the result that there is negative relationship
between leverage and M/B so as for equity issues.

Overall
the study focuses on stock exchange whether it has any connectivity with firm
financing and other related issues. Based on the hypothesis it explained that
there is tendency in firm to increase its shares through equity and same the
ration of M/B will be associated with it too to measure the impact. The result
show a slightly significant relationship which is yet to be explained further
to show the leverage impact.

Poleraiah (2015 );
This theory being reviewed in different market to check the overall off set. In
this particular study where some reviews were rejected to a point like Theory
of Modigliani and Miller, however Trade off and pecking theory was accepted to
review the issues arise in timing the market. Funding is the most important
factor firm faces, finance in the longer run or shorter. Firstly it says that
capital structure play a vital rule, secondly trade off theory assumes that
equity financing can better be controlled and tackle market imperfections i.e.
costs like bankruptcy costs and taxes. Lastly Pecking theory says debt
financing equity financing is far more than equity financing when it comes to
company facings issues in issuing securities.

We
use data from financial statements of Indian companies that were listed on the
national Stock Exchange (NSE) during the period 2000 to 2015.

Data
from Indian companies were took from 2000 to 2015. Regression analysis will be
run to see the changes and effect on overall investment decisions. From IPOs
till the company profits. As the study is still under observation to determine
the results. Though through sample study negative relationship is expected to
be found.

(Clarke, FitzGerald et al. 1989) Most important that been raised in
the theory, that market timing can a factor that helped a manager to beat
market in earning more money? Even after many studies it stated that timing the
market nearly impossible. Which was later discussed by Sharpe’s in an argument
that it’s better to invest rather to hold money in hand for abnormal profits.
All it depends on manager’s predictability. Later on focused study, rules to be
followed, investment can be done following an optimal rule in stocks
investment. For that information or related needs to be in hand in an accurate
manner. If holding period exceed the time to investment zero profit earning
ration is expected. But according the thumb rule, an entity when make an
investment, maximum profit is aimed. This will ultimately reduce the
transaction cost by not holding money for so long. On doing this investor will
have to pay 1% cost, if they have perfect related information about the stock
market.

Return
on investment will going to increase as per available information. But that
does not mean all the investor will get expected returns. Hence, beating market
timing does not mean we will get more money.

Criticism

In
financing corporate, one of the most important issues is to find an appropriate
method to make a wise selection between getting loans and increasing the number
of shares. Before moving forward, let me give you glimpse of some other
theories i.e. Trade-Off Theory, Pecking Order Theory and Market Timing Theory.
These were the important concepts to know, as (Huang and Ritter (2005), Jahanzeb
2013);Poleraiah (2015 );Luigi and Sorin (2009)
and many other authors compare this theory with Market timing theory.

Trade-Off
Theory:

Trade-off
theory comprises on how much debt finance and how much equity finance should
firms used by balancing the costs and benefits. (Jahanzeb 2013) discussed the tax shield provided
by the debt financing i.e.; tax shields to the earnings. But at the same side (Henriksson and Merton 1981) compare the costs and the benefits
of debt and potentially discussed about bankruptcy costs and agency conflicts
between bond holders and shareholders. Theory suggested that firms should issue
equity when their leverage is above the desired target and issue debt when
leverage is below the target, or issue debt and equity respectively to stay
close to the targeted leverage.

Pecking
Order Theory:

(Huang and Ritter 2005) explained that firms had postulate
order of financing.Most of the firms
prefer internally generated funds, and raise external funds only if internal
funds are insufficient. If external funds are required, they prefer straight
debt, then convertible debt, and finally external equity. The main difference
between the pecking order theory and the market timing theory is the
semi-strong form of market efficiency assumed.

Comparison
with Market Timing Theory:

Market
timing theory is all about window of opportunity. As it is discussed previously
in detail, states that firms prefer external equity when the cost of equity is
low, and prefer debt otherwise.

(Huang and Ritter 2005) compares these theories and
concluded that Market timing theory is a challenge for both of the other
theories, because Market timing theory provides an adequate explanation on
time-variation but others were fail to do. So, he supported Market timing
theory but also concluded that security issue or capital structure decisions
were not durable, theory still need more work in this context.

(Jahanzeb 2013) refers that market timing theory
evidently proved, manger wait for the stocks position to get better (increase
in prices of stocks) before issuing new stocks. As other theories explained the
capital structure extensively, but Market timing does required to incorporate
dynamic models which will furnish assumed results and theoretical results in
order to understand the complexity of these theories in a better way.

(Virk, Ahmed et al. 2014) discussed the financing decisions
in Pakistan regard to market timing theory. In his studies, he doesn’t support
market timing theory. He suggested that firms in Pakistan shouldn’t issue
equity during the high variations. It may be due to underdeveloped equity and
debt markets for Pakistan and also because Pakistan is facing the issue that
managers are using the firms excess resources which led firms to use more debt,
or this might only be due to the fact that mostly firms use short term
financing in the case of Pakistan.

Market
timing theory still needs to explore that, why some firms tends to issue equity
while other issue debt at the same time. Nobody has explained this problem
within a model of market timing. Therefore market timing is seen as incomplete
theory.